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Tuesday, April 27, 2010

Basic of Options

Option, an instrument used for hedging by taking a view on the future direction of market which help in generating income for investors under various market conditions. Option can be simply defined as a contract which gives the buyer the right but not the obligation to buy (call option) or to sell (put option) a particular asset at a particular price in future. For every option, buyer has to pay an amount to the seller know as Option premium or option price.

Here, I would try to explain the basic options payoffs. It is a known fact that option results in non-linear payoff i.e. losses for buyer of an option is limited whereas profits are potentially unlimited.

Long Asset (Without option)

Long refers to buying the asset at the underlying price when investor perceives the market to be bullish. For example, buyer buys a share of XYZ Ltd at Rs 2500 and decides to sell it at a future date at an unknown price. The investor is said to be ‘long’ the asset. As expected if market turns out to be bullish such that share prices goes up, buyer makes profits and if share price falls, he loses.

Short Asset (Without Option)

Short refers to selling of asset at the underlying price and buys it back at a future date at an unknown price. Once the share is sold, the investor is said to be ‘short’ the asset. For example, buyer sells a share of XYZ Ltd at Rs 2500 as he perceives the market to be bearish. If share price falls, he profits and vice versa.

Buyer of Call Options (Long Call)

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. Now here the profit/ loss of the buyer depend on the spot price of the share. In this case, buyer along with the share (Long Asset) buys an option at the premium price which he pays to the seller of the option. Every option has an expiration date and strike price (K) which is specified in the option contract.If upon expiration, spot price > strike price (In the Money), buyer makes a profit. If spot price < strike price (Out of the Money), buyer lets the option expire un-exercised. His loss is them limited to the premium he paid for buying the option.For example, if buyer buys a 3 month (expiration date) Nifty 2500 call option at a premium of 100. If upon expiration spot price is 3000 then buyer makes a profit of 400 (3000-2500+100). However if spot price is 2100, buyer lets the option expire and his losses are limited only to Rs 100 (the premium).

It is important to remember that profit for buyer of call option is unlimited and losses are limited.

Seller of Call Options (Short Call)

Seller or Writer is the one who charges the premium to the buyer of call option. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, spot price exceeds strike price, buyer will exercise the option on writer thus writer start making losses. However when buyer let the option expire un-exercised (strike price>spot price) writer gets to keep the premium which is his profit.

It is important to remember that profit for seller of call option is limited and losses are unlimited.

Buyer of Put Options (Long Put)

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. Profit/loss of buyer again depends on the spot price of the underlying. Upon expiration if spot price is below strike price (In the Money), buyer makes a profit. If spot price > strike price (Out of the money), buyer makes a loss. His loss is again the premium he paid to the seller of put option.

It is important to remember that profit for buyer of put option is unlimited and losses are limited.

Seller of Put Options (Short Put)

Seller or Writer is the one who charges the premium to the buyer of put option. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, strike price exceeds spot price, buyer will exercise the option on writer thus writer start making losses. However when buyer let the option expire un-exercised (spot price>strike price) writer gets to keep the premium which is his profit.

It is important to remember that profit for seller of put option is limited and losses are unlimited.

The above explained six payoffs are the basic ones which are molded and redervied to form various option strategies used by investors to maximize their profits and minimize risks. I will try to explain it more clearly through graphs in my next blog.